How Badly Has the U.S. Economy Been Damaged?

Friday’s employment report, which shows that payrolls rose by two hundred and four thousand jobs in October, indicates that the economy was a bit stronger in the past three months than most people thought. But we won’t know the full impact of the government shutdown and the debt-ceiling crisis for a while yet, and it is fanciful to suggest that one better-than-expected jobs report will persuade the Federal Reserve to change course and start withdrawing some of its monetary stimulus.

Trying to sort the signals from the noise in the jobs report is a tough task in the best of times: the margin of error for the payroll figures is plus or minus ninety thousand jobs. So instead I’ll say a few things about a new research paper by three economists at the Federal Reserve, which is getting a lot of attention because it suggests that the recession and its aftermath have not only done terrible things to the U.S. economy in the immediate sense—high rates of joblessness, tepid gross-domestic-product growth, falling incomes—but also seriously undermined the economy’s capacity for future growth. Gavyn Davies, of the Financial Times, drew attention to the study earlier this week; Reuters published a story about it; and, in today’s New York Times, Paul Krugman devoted an entire Op-Ed to it, which was perfectly justified. It deserves to be discussed widely.

The authors of the paper are David Wilcox, the head of economic research at the Fed, and two of his colleagues, William Wascher and Dave Reifschneider. Although the study uses some sophisticated statistical methods, its basic point is straightforward: in the long term, economic output (G.D.P.) is constrained by the quantity and the quality of economic inputs (labor, capital, and technology). If the growth rate and quality of these inputs decline, the potential growth rate of G.D.P. will fall, too—it’s just a matter of arithmetic.

Since the financial crisis of 2007, the authors argue, that’s precisely what has happened. With hiring rates down, many workers have given up searching for jobs and have dropped out of the labor force. (According to today’s employment report, the labor-force participation rate hit yet another low in October: 62.8 per cent.) With budgets tight, corporations and government departments have cut back on investments in new plants and machinery, computer hardware and software, and research and development. And, with investments in innovation depressed, the rate of over-all productivity growth has slowed down.

If you put all of these things together, they seem to suggest that the economy’s capacity for growth is lower than it was before the financial crisis. How much lower? The authors come up with a variety of numbers, including one that has received a lot of attention: potential G.D.P.—broadly speaking, the level of G.D.P. consistent with stable inflation—“is currently about 7 percent below the trajectory it appeared to be on prior to 2007.” According to the latest figures from the Commerce Department, the G.D.P. is now close to seventeen trillion dollars, and seven per cent of that figure is $1.2 trillion. This is a lot of money to have gone missing, especially if it will never be recovered. Hence Krugman’s dire conclusion: “By tolerating high unemployment we have inflicted huge damage on our long-run prospects …. What passes these days for sound policy is in fact a form of economic self-mutilation, which will cripple America for many years to come.”

The above chart, which is taken from the paper, shows the shortfall in potential G.D.P. relative to the prior trend. As well as figuring out the current level of potential G.D.P., the authors estimate its growth rate. This is the more important figure, because it’s what determines living standards over the long term. Here, too, their findings are very depressing. In the period from 2000 to 2007, the paper says the average potential growth rate of G.D.P. was 2.6 per cent. For 2012, the authors estimate the potential growth rate at only 1.3 per cent. Taken at face value, these figures suggests that the growth potential of the U.S. economy has been cut in half.

It’s good to see economists at the Fed acknowledging that recessions, and periods of meagre growth, can have serious long-term costs in addition to their short-term effects. This isn’t a new idea, mind you. After the Second World War, it was prevalent in the work of Keynesian economists like Nicholas Kaldor, who emphasized the importance of positive-feedback loops in employment and growth. In the nineteen-eighties, Larry Summers and Olivier Blanchard, who is now the chief economist of the I.M.F., resurrected the idea and gave it a new name, which they borrowed from engineering: hysteresis. Blanchard and Summers examined hysteresis in Europe, where high rates of unemployment have long been a problem. Today, it’s clearly an issue in the United States, which has had five years of elevated joblessness and subpar growth. You don’t need a mastery of econometrics to grasp the idea that low levels of investment and persistently elevated rates of unemployment are doing some serious damage to the supply side of the economy.

That’s the bad news. The good news is that things aren’t quite as bad as the figures in the Fed paper might suggest. If we can get policy right and sharply increase the level of over-all demand in the economy, most of the damage done in the past five years is reversible. Just as running an economy at low levels of demand generates self-reinforcing processes that are harmful, running an economy at high levels of demand has the opposite effect: capital investment rises, retired and discouraged workers return to the labor force, small-business formation surges and innovations spread more rapidly, productivity increases, and the unemployment rate consistent with stable inflation falls.

We saw this in the late nineteen-nineties, when G.D.P. grew at an annual rate of more than 4.5 per cent, the unemployment rate fell to four per cent, and the labor-force participation rate rose to sixty-seven per cent, while inflation remained quiescent. Unfortunately, of course, these positive developments were attended by a speculative bubble in the stock market, which eventually burst. But the key point stands. If we can get the economy to grow faster, the growth will be self-reinforcing, and it could almost certainly be sustained at levels higher than current estimates of the potential growth rate suggest, including the ones in the Fed paper.

In fact, while the authors have done a good job of pointing out that the costs of low growth are large, their estimates of the economy’s long-term growth capacity should be taken with a pinch of salt. In all such statistical exercises, the researchers extrapolate from recent data. Whenever the actual growth rate of G.D.P. falls, the statistical model spews out a conclusion that the potential growth rate has fallen, too. But determining long-term trends from data collected over short periods is notoriously difficult. Is it realistic to suggest that the economy’s capacity to expand has halved in five years? Population growth hasn’t ceased. Americans aren’t any less hardworking than they were five years ago, and their skills haven’t declined precipitously. Scientific and technical progress is continuing.

The Fed economists, to their credit, do acknowledge that their analysis may overestimate the long-term damage that has been done. They note that “a substantial portion of the slowdown in the adjusted growth rate since 2007 reflects an unusually slow pace of capital deepening—a factor whose contribution to growth should pick up substantially over time as the recovery in business investment and the broader economy proceeds.” My guess is that the economy’s growth potential is just about the same as it has been for the past century or so. If you look at the second graph (below), which I took from a piece by Mark Thoma, of the University of Oregon, it shows that between 1870 and 2008 the economy’s growth rate has been remarkably steady. (In the graph, G.D.P. is inflation-adjusted and measured on a logarithmic scale. A straight line indicates a constant rate of growth.)

The graph stops in 2008. If we were to extend it to 2013, the slope of the line would fall sharply. But what that tells us is not necessarily that the economy’s capacity to expand—and to generate higher living standards—has declined permanently but, rather, that we need an extended period of above-average growth to get us back on the historic trend line. If you look at the middle part of the graph, you see that that is what happened in the nineteen-thirties and forties: following the Great Depression, there was a burst of very rapid growth, which restored the economy to its prior path.

Of course, that rapid growth coincided with the Second World War, when, under the guise of scaling up the military to fight Hitler, the U.S. authorities subjected the economy to an enormous fiscal-stimulus program. At the moment, sadly, there is no prospect of any more fiscal stimulus, let alone a war-sized one, and the onus is falling on the Fed to gee up the economy. With regard to policy, the importance of the new research paper is that it gives its authors’ prospective boss, Janet Yellen, more ammunition to maintain a highly accommodative policy going forward. In the presence of hysteresis, the authors note, there is a strong argument for monetary policymakers “to be more activist, in order to mitigate the possible damage to the current and future supply side of the economy.” I’m pretty sure that Yellen knew this anyway. But now she can point to an authoritative internal study backing up her intuition.